Saturday, October 12, 2013

The Dollar Losing Reserve Currency Status

We use the term “reserve currency” when referring to the common use of
the dollar by other countries when settling their international trade
accounts. For
example, if Canada buys goods from China, it may pay China in US dollars
rather than Canadian dollars, and vice versa. However, the foundation
from which
the term originated no longer exists, and today the dollar is called a
“reserve currency” simply because foreign countries hold it in great
quantity to
facilitate trade.

The first reserve currency was the British pound sterling. Because the
pound was “good as gold,” many countries found it more convenient to
hold pounds
rather than gold itself during the age of the gold standard. The world’s
great trading nations settled their trade in gold, but they might hold
pounds
rather than gold, with the confidence that the Bank of England would
hand over the gold at a fixed exchange rate upon presentment. Toward the
end of World
War II the US dollar was given this status by international treaty
following the Bretton Woods Agreement. The International Monetary Fund
(IMF) was formed
with the express purpose of monitoring the Federal Reserve’s commitment
to Bretton Woods by ensuring that the Fed did not inflate the dollar and
stood
ready to exchange dollars for gold at $35 per ounce. Thusly, countries
had confidence that their dollars held for trading purposes were as
“good as gold,”
as had been the Pound Sterling at one time.

However, the Fed did not maintain its commitment to the Bretton Woods
Agreement and the IMF did not attempt to force it to hold enough gold to
honor all
its outstanding currency in gold at $35 per ounce. The Fed was called to
account in the late 1960s, first by France and then by others, until
its gold
reserves were so low that it had no choice but to revalue the dollar at
some higher exchange rate or abrogate its responsibilities to honor
dollars for
gold entirely. To it everlasting shame, the US chose the latter and
“went off the gold standard” in September 1971.

Nevertheless, the dollar was still held by the great trading nations,
because it still performed the useful function of settling international
trading
accounts. There was no other currency that could match the dollar,
despite the fact that it was “delinked” from gold.

There are two characteristics of a currency that make it useful in
international trade: one, it is issued by a large trading nation itself,
and, two, the
currency holds its value vis-à-vis other commodities over time. These
two factors create a demand for holding a currency in reserve. Although
the dollar
was being inflated by the Fed, thusly losing its value vis-à-vis other
commodities over time, there was no real competition. The German
Deutsche mark held
its value better, but German trade was a fraction of US trade, meaning
that holders of marks would find less to buy in Germany than holders of
dollars
would find in the US. So demand for the mark was lower than demand for
the dollar. Of course, psychological factors entered the demand for
dollars, too,
since the US was seen as the military protector of all the Western
nations against the communist countries for much of the post-war period.
Today we are seeing the beginnings of a change. The Fed has been
inflating the dollar massively, reducing its purchasing power in
relation to other
commodities, causing many of the world’s great trading nations to use
other monies upon occasion. I have it on good authority, for example,
that DuPont
settles many of its international accounts in Chinese yuan and European
euros. There may be other currencies that are in demand for trade
settlement by
other international companies as well. In spite of all this, one factor
that has helped the dollar retain its reserve currency demand is that
the other
currencies have been inflated, too. For example, Japan has inflated the
yen to a greater extent than the dollar in its foolish attempt to revive
its
stagnant economy by cheapening its currency. So the monetary destruction
disease is not limited to the US alone.

The dollar is very susceptible to losing its vaunted reserve currency
position by the first major trading country that stops inflating its
currency. There
is evidence that China understands what is at stake; it has increased
its gold holdings and has instituted controls to prevent gold from
leaving China.
Should the world’s second largest economy and one of the world’s
greatest trading nations tie its currency to gold, demand for the yuan
would increase and
demand for the dollar would decrease. In practical terms this means that
the world’s great trading nations would reduce their holdings of
dollars, and
dollars held overseas would flow back into the US economy, causing
prices to increase. How much would they increase? It is hard to say, but
keep in mind
that there is an equal amount of dollars held outside the US as inside
the US.

President Obama’s imminent appointment of career bureaucrat Janice
Yellen as Chairman of the Federal Reserve Board is evidence that the US
policy of
continuing to cheapen the dollar via Quantitative Easing will continue.
Her appointment increases the likelihood that demand for dollars will
decline even
further, raising the likelihood of much higher prices in America as
demand by trading nations to hold other currencies as reserves for trade
settlement
increase. Perhaps only such non-coercive pressure from a sovereign
country like China can wake up the Fed to the consequences of its
actions and force it
to end its Quantitative Easing policy.

About Me

I am an investment analyst, portfolio manager, and CFA Chartholder that has worked on both the buy side and sell side in various roles including analyst, portfolio manager, and trader. I have over ten years of experience in the investment industry and characterize my investment style as having a leaning towards value. This blog will track my (and potentially guest author) opinions, managed portfolios, and investment ideas.